A Presentation on

Presented to: Presented by: Nikunj Patel Sachin Nandha

Sandip Gunge

Introducton

• The theory of purchasing power parity (PPP) explains movements in the exchange rate between two countries’ currencies by changes in the countries’ price levels.

The Law of One Price Law of one price

• Identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency.

– Example: If the dollar/pound exchange rate is $1.50 per pound, a sweater that sells for $45 in New York must sell for £30 in London.

PiUS = (E$/€) x (Pi

E)

where:

PiUS is the dollar price of good i when

sold in the U.S.

PiE is the corresponding euro price in

Europe

E$/€ is the dollar/euro exchange rate

The Law of One Price

Purchasing Power ParityEPPP

$/€ = PUS/PE

where:

PUS is the dollar price of a reference commodity basket sold in the United States

PE is the euro price of the same basket in Europe

CountryGDP (PPP) $

United States 13,811,200

Eurozone 10,371,393b

People's Republic of China 7,055,079

Japan 4,283,529

India 3,092,126

Germany 2,727,514

Russia 2,088,207

France 2,061,884

United Kingdom 2,046,780

The Relationship Between PPP and the Law of One Price• The law of one price applies to individual

commodities, while PPP applies to the general price level.

Purchasing Power Parity

Absolute PPP and Relative PPP• Absolute PPP

• Relative PPP

Purchasing Power Parity

• The monetary approach makes a number of specific predictions about the long-run effects on the exchange rate of changes in:

– Money supplies

– Interest rate

– Output levels

A Long-Run Exchange Rate Model Based on PPP

Empirical Evidence on PPP and the Law of One Price

The Dollar/Exchange Rate and Relative U.S./German Price Levels

The failure of the empirical evidence to support the PPP and the law of one price is related to:• Trade barriers and nontradable

• Departures from free competition

• International differences in price level measurement

Explaining the Problems with PPP

PPP in the Short Run and in the Long Run• Departures from PPP may be even greater in the short-

run than in the long run.– Example: An abrupt depreciation of the dollar against

foreign currencies causes the price of farm equipment in the U.S. to differ from that of foreign’s until markets adjust to the exchange rate change.

Explaining the Problems with PPPPrice Levels and Real Incomes, 1992

The Real Exchange Rate

Real depreciation of the dollar against the euro

Real appreciation of the dollar against the euro is the opposite of a real depreciation.

Demand, Supply, and the Long-Run Real Exchange Rate

Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates

• There are two specific causes that explain why the long-run values of real exchange rates can change:

– A change in world relative demand for American products

– A change in relative output supply

Nominal and Real Exchange Rates in Long-Run Equilibrium

Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates

The most important determinants of long-run swings in nominal exchange rates (assuming that all variables start out at their long-run levels):

A shift in relative money supply levels

A change in relative output demand

A change in relative output supply

When all disturbances are monetary in nature, exchange rates obey relative PPP in the long run

Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates

Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates

The Real Dollar/Yen Exchange Rate, 1950-2000

Sectoral Productivity Growth Differences and the Change in the Relative Price of Nontraded Goods, 1970-1985

Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates

Thank You